A disappointing day for risk assets yesterday threatens to advance further.Weaker than expected data from China and the US dragged on market sentiment supporting the theory that the worldwide economy is repeating the pattern of Q1 strength followed by weakness over the remainder of the year.

Growth fears aided to worsen the drop in gold prices with the valuable metal plummeting by 15.5% this month alone whilst weighing heavily on other commodity prices.

Data releases today include CPI inflation in the US, Eurozone and UK alongside the German ZEW investor confidence survey, US industrial production and housing starts.

The Eurogroup and Ecofin statement of an extension of Irish and Portuguese loans and the disclosure that Cyprus will need even more funds than previous estimates (EUR 23 billion compared to EUR 17.5 billion previously) has been taken in its stride by markets.

Given market sensitivity to weak data any discontent will strengthen the risk off tone but this appears doubtful as the data overall is expected to be somewhat healthier.

The Aussie was struck by weaker Chinese data releases and worsening in risk appetite.

While the drop has been sharp over recent days Australian Dollar is unlikely to fall much more, with an abundance and sufficient appetite for the currency around 1.0300. Nevertheless, AUD/USD has dropped below its 100 day moving average level 1.0414 – a breach of which threatens to mark a stronger downward move.

Finally, UK Inflation is expected to rise another 2.8% in March and persistent price growth may increase the demand for Sterling as it diminishes the Bank of England’s (BoE) space to expand on QE.

As the central bank expects a slow but sustainable recovery in Britain, above-target inflation should keep the MPC on the side-lines, and we may see a growing number of BoE officials adopt a more neutral to hawkish tone for monetary policy as the Funding for Lending Scheme continues to work its way through the real economy.

Money market traders will be preoccupied by today’s US Presidential election and Thursday’s handover of leadership in China.The US Dollar appears to be rallying in spite of a narrow lead in the polls by President Obama.

The general view is that a Romney win would be US Dollar positive given that it may imply a more restrictive Fed in the form of less QE but the USD appears to be ignoring such polls.

The single European currency is the weakest performing currency so far this month after the Swiss Franc.

Greek and Spanish fears are mounting pressure on the euro- the former due to tomorrow’s vote on austerity procedures and the latter due to worsening economic data and a lack of traction towards requesting a bailout and therefore triggering the ECB’s bond purchase program.

If we look to the bond markets, a switch in Germany 2 year bond yields have turned negative, producing a widening US yield gain and in turn a weaker EUR/USD.

Certainly, the relationship across 2 year US – German yield differentials is very high, suggesting that the EUR will struggle below its 200 day moving average around 1.2828 until German yields move higher.

A generally firmer US Dollar has also dealt a blow to Sterling, with the currency slipping below 1.60.

This decline was supported yesterday by poor service activity in the UK which increased at the slowest pace since a temporary decline in activity nearly two years ago.

The PMI Index for services in October fell to 50.6 from the prior month’s 52.2 PMI, lower than the expected 52.0.

The number is a reminder that despite the recent strong GDP number the UK still has problems within manufacturing and service industry.

Therefore attention will return to the Bank of England decision on Thursday, where the decision will be a close call but there is a possibility of an additional GBP 25 billion in asset purchases could be announced.

Sterling could encounter some problems in this event but given that the currency has not been particularly impacted from QE in the past, it is unlikely it will suffer any severe setbacks.

German IFO business confidence posted its fifth straight monthly decline yesterday, dragging the Euro lower against the US Dollar and Sterling. Although the German economy has remained out of recession, the IFO number suggests that there is a growing possibility that the eurozone powerhouse is starting to sag under the weight of supporting the struggling periphery.

Adding to European woes are budget problems In Portugal and surprise surprise- Greece.

The Portuguese are under pressure to increase tax levels and announced increased social security contributions.

The move sparked protests and forced the government into a U-turn but the conditions set by the EU-IMF bailout are binding and tax increases will need to found.

The recent climb down only delays the process for a few weeks.

In Greece yet another rumour is doing the rounds about a financing hole.

The suggestion was made by the German newspaper Der Spiegel and was swiftly denied by the Greek government, who suggested the ‘gap’ would be met buy further austerity measures currently being finalised. Sound familiar?

For the rest of the week the only other data of interest is the 2Q final GDP revisions from the UK and the US.

It is very unlikely that any changes will be made so expect calmish markets for the remainder of the week before we get the BoE & ECB rate decisions and the non-farm payrolls next week.

A surprise increase in the US ISM manufacturing survey yesterday evening was enough to push the Dow Jones industrial average to its highest level in four years, dragging European bourses higher this morning along with the high risk currencies. Due to the May Day bank holiday in Europe, markets on the continent are playing catch up with the US and UK and are performing very strongly in early trading.

Chinese manufacturing PMI also showed a slight improvement overnight, but is still below the 50.0 level, signifying a contraction in manufacturing output.

This afternoon the ADP employment report is released in anticipation of the non-farm payrolls on Friday with expectations of 175K jobs created in April, not quite the numbers we saw in the first three months on the year but positive non-the-less.

Portugal goes to the market today, issuing six and twelve month treasury bills.

The target amount is only €1.25-1.5 billion, but the auctions will be closely watched as ever and expect overblown hysteria if we any signs of weakness.

Ahead of the auction the spread between the benchmark ten-year bonds is slightly higher, sitting at 902 bps in current trading.

The euro is marginally weaker this morning against the US Dollar and Sterling.

From the data just out, French and German PMI were broadly in line with the flash estimates but German unemployment rose in April and it is this that is leading the Euro weakness this morning.

Against all the odds the single European currency has been resilient this week moving up towards the year to date highs of 1.3068, clawing back its losses and more.

The euro’s ability to defend bad news in Europe has been remarkable and its gains have reflected a speculative market that has been extremely short.

As we are light on headline data today the markets will have to observe the outcome of the somewhat positive Spanish and French debt auctions while keeping one eye on Greek debt talks with private investors.

But for yet another failure of talks in Greece the EUR should continue on a positive footing.

How long this will last is uncertain, particularly given the dangers ahead but at a time when investors have become progressively more bearish on the euro it may just extend its bounce over the short term.

One country to watch is Portugal whose bonds have underperformed recently as markets speculate that it could be the next contender for any debt note.

Back to the UK and Retail sales have come been announced close to median forecasts of +0.6% m/m and +2.6y/y.

Sales have improved in December but the improvement is likely to be short-lived, suggesting any support to the Pound will be brief.

Sterling has underperformed even against the firmer EUR of late but this is supporting better levels for the market to take long positions versus EUR.

This explains the move in relative European/US interest rate differentials, which has been linked with the move in EUR/GBP.

Overall Sterling could outperform EUR over coming months to around 0.80, with the former continuing to benefit from the simple fact that it is not in the Eurozone and has therefore acquired a quasi safe haven status.

A new shockwave filtered through the markets on Friday as the credit agency Standard & Poors (S&P)- downgraded France, stripping them of its prized AAA rating. The decision to remove this vital asset in keeping borrowing costs to a minimum left France with a AA+ rating, a judgment that will likely cost billions in higher repayment costs.

S&P said “Europe’s austerity and budget discipline alone were not sufficient to fight the debt crisis and may become self defeating”.

Alongside France, S&P cut the rating of Italy, Spain, Cyprus, Portugal, Austria, Slovakia, Slovenia and Malta though it was expected that these countries would have their ratings lowered.

Overall, the picture isn’t looking good for Europe and with further downgrades likely over the next few months, it will be important to see how the ECB reacts in keeping this ongoing debt crisis under control.

The main winner from this continues to be the US Dollar with further gains against most currencies likely as investors pile more money into the global reserve currency.

For as long as the Greenback keeps this status, it will remain the market leader in these testing times as Europe sits on a knife edge between growth and recession.

There is very little data out today with the only comment of note coming from a speech by ECB President Mario Draghi due at 6pm UK Time.

It is likely he will focus on the downgrade on France and how the ECB will look to repair the damage it has caused.

The president of the European Council has said that a summit of EU leaders to discuss the eurozone debt crisis has been delayed by a week.Herman Van Rompuy said more time was needed to finalise a plan to give money to Greece and bolster debt laden banks.

The summit, originally planned for next Monday and Tuesday, will now start a week later on 23 October.

European regulators and the leaders of Germany and France have been engaged in intense talks for several days.

Mr Van Rompuy said in a statement that the delay will allow the EU “to finalise our comprehensive strategy on the euro area sovereign debt crisis covering a number of interrelated issues.”

The 27 nation EU, and in particular the 17 country eurozone members have found themselves under growing market pressure to finally act.

Fears that Greece and other highly indebted countries will default on their debts, and cripple the banks that hold their bonds, have sent shockwaves through financial markets.

On Sunday, German Chancellor Angela Merkel and French President Nicolas Sarkozy said they were close to agreeing a comprehensive new package to ease the eurozone’s debt crisis. However, they gave no details.

Mr Van Rompuy also said he had asked for an additional meeting of EU finance ministers ahead of the 23 October summit, so they can lay the groundwork for the leaders’ decision.

After dipping briefly under 1.60 over the past week, the Sterling-Dollar pair snapped back sharply in late trading last night as firstly Fed Chairman Ben Bernanke refused to rule out further QE and secondly, after threatening to do so last month, Moody’s placed the US on review for a downgrade of its credit rating. Although Mr Bernanke did not outline much more than the market already knew from the minutes from the last Fed meeting, the fact that the words came from his mouth and not in text seemed enough of a reason for traders to sell the Dollar off against the Euro and Sterling, with cable jumping one and a half cents in quick time.

The potential ratings downgrade came as US President Barack Obama walked out of budget talks, raising the fear that a deal on raising the US debt ceiling before the US Government runs out of money is looking increasingly unlikely.

Later today US retail sales are due, and will probably show a modest decline, as retail sales ten to do over the summer months.

On Friday we also have the US CPI number and the U of Michigan confidence survey.

With EU banking stress tests due late on Friday evening, we’ve had the first indication that some of the banks are struggling to pass.

German public sector bank Helaba is rumoured to have pulled out, giving regulators a real headache the day before the results are due.

The key point in doing a second round of stress tests was their credibility, and the fact that it would cover all systemically important EU banks.

If Helaba pulling out marks the first of several banks following suit, the whole purpose of the project, namely to restore confidence in the European banking system will be undermined.

After the market volatility in Italian bonds and bank shares, this morning’s Italian Debt auction takes on more significance.

With many economists suggesting Italy is too big to fail, any sign of weakness will be magnified hugely.

Speculation is mounting that the ECB or Italian central bank may buy some of the bonds to signal to the market that demand is high and to keep yields suppressed.

As we know with Greece, Ireland and Portugal when the cost of insuring the bonds raises above 400 basis points bad things start to happen; both Spain and Italy remain around 300.

Even with all the negative Euro news, the news from the US yesterday evening has pulled the Euro higher against both Sterling and the Dollar.

As much as European bankers try to stop it, contagion appears to be spreading through the Eurozone with Italy’s high debt burden and lack of political will leading to more emergency meetings. Reports that their debt stands at double Greece, Ireland and Portugal combined led to equity markets slumping and bond spreads jumping.

Europe signed a treaty to establish a permanent €700bn bailout fund, but this is only available from 2013.

In the meantime, a second bailout for Greece is still being agreed with the hope this will shield Italy.

Last night, Moody’s downgraded Ireland into the junk territory saying “it is likely that, like Greece and Portugal, Dublin will need another bailout before it can return to the markets.

Meanwhile, the UK received some unexpected news with a fall in inflation; the first negative number for June since 2003.

The figures showed CPI inflation rising by 4.2% against expectations of 4.5%.

This gave a mixed view for the UK economy as on the positive side, it shows the huge rise in inflation potentially starting to tail off and drop towards the target level.

Unfortunately, the main reason for things becoming cheaper is retailers having to slash prices to entice the public to spend what little cash they have.

Overall, Sterling was pretty steady after these figures and moves were mostly as a by product of massive swings in Eurodollar.

The volatility has continued today as the uncertainty surrounding many of the worlds markets has left traders and investors with massively diverging opinions.

It seems to be “watch this space” at the moment while we wait for more news out of Europe.

EU members scrambled yesterday to avoid the debt crisis in Greece from destabilising the currency union, threatening credit-rating agencies with possible retaliation following the decision by Moody’s to lower Portugal’s debt to junk status.With the downgrade came a warning that Portugal similar to Greece may require a second bailout pushing European equities lower yesterday and bond spreads higher.